Tuesday, May 31, 2011

This piece is primarily commercial, so be forewarned. It did not start out that way, but as I was thinking of our industry and how it has evolved that became the result. You see, our firm had no need to be bailed out in the fall of 2008.

At lunch last Thursday I listened to Bill Cohan discuss his new book, Money and Power, subtitled “How Goldman Sachs Came to Rule the World.” What struck me was how different Wall Street is today than it was when I joined Merrill Lynch Training Class 105 in September, 1967. The story Mr. Cohan told was not a revelation. After all, I spent a dozen years at Salomon Brothers in the 1980s and very early 1990s. I have known prop traders and watched their desks. I have benefited from their successes. I witnessed what “portfolio insurance” did for markets in 1987. Like most of you, I nervously watched the near collapse of our financial system from the Lehman bankruptcy on September 15, 2008 to the decision to save Citigroup on November 24th. Again, giving insurance a bad name, the role played by Collateralized Debt Securities (CDSs) was one of the main accelerants of the crisis. (The principal cause, in my opinion, was too much leverage, not only within banks, but with consumers as well. Local, state and federal governments are still overleveraged.) I have read dozens of books on the reasons for the crisis, and I have written even more notes and thoughts on my perception of those days and what precipitated them. Nevertheless, Money and Power is a book worth reading.

When I entered the business, it was a customer-driven business. Whether one was dealing with corporations, institutions or individuals, satisfying the needs of the client came first. Most of us felt lucky that we had found the industry. It was dynamic; the clients were intelligent, successful and interesting. Every conceivable piece of news had some impact, so it paid to be alert and informed. It was interesting, lively and, not least important, financially rewarding.

In 1967 when I first joined Merrill Lynch, all firms were partnerships. That meant that every partner was jointly and severally liable. The knowledge that one’s home could be sold to satisfy creditors served as a governor on the type of risk one was willing to assume. Wall Street firms began going public in the late 1960s, with Donaldson, Lufkin, Jenrette and Merrill Lynch being the first. The trend accelerated in the 1980s and 1990s. Goldman was the last large partnership, finally succumbing in May 1999. And with the disappearance of partnerships went fiscal discipline. Risk was transferred to shareholders, while returns remained with the partners. In 2008, risk was assumed by taxpayers, while returns remained the province of the partners.

I have spent my entire career in the customer business. But a significant portion of Wall Streeters have straddled both the agency and principal sides of the business. During the 1980s, the proprietary desks at large firms, like Salomon, Goldman and Morgan Stanley were generating enormous profits, effectively competing against many of their clients. They were able to do so, in part because interest rates were declining and because they were able to take speedy advantage of momentary inefficiencies that periodically develop in markets. High Frequency Traders, both within publically traded investment banks like Goldman and private hedge funds like Renaissance Capital, have now largely reduced those spread opportunities for all but the most nimble. Glass-Steagall, which in 1933 caused banks to separate their investment banking operations from their commercial banking businesses was rescinded in 1999 when – you guessed it – another Goldman managing partner, Robert Rubin, was Secretary of the Treasury. That decision effectively allowed investment banks to use customer deposits to fund their own trades – to take a liability that was motivated by safety and use it to fund an asset whose return was predicated on risk.

In contrast, our firm is all about the customer. We have no other business. At the age of twenty-seven, Andy Monness started the firm in the summer of 1964. Its purpose was to provide research and trading to institutional and high net worth clients. Everything is the customer. Neil Crespi, fresh out of college, joined Andy in 1976. It has been a combination of his selling skills and his business acumen that have guided the firm for the last three and a half decades. In 1980 Herb Hardt joined the firm as head of research after putting in eight years with Fidelity. He has two degrees from Harvard and had earned U.S. Army captain’s bars while serving in Vietnam. On our desk we have young people fresh out of college; we have others with ten or more years of experience, and older ones with many years of experience on both sides of the Street who provide unique insights into markets and individual stocks. In our research department we have everything from a Yale medical doctor to a former member of the Israeli Army. And, in Neil’s son Robbie, we have, in my opinion, the single best salesman I have known – and I have known a lot of them.

It constantly amazes me that so many institutional clients feel compelled to deal with firms whose profits are driven by lines of business that are not client centric and, in fact, are often in direct competition with the interests of their clients. Perhaps this is prejudice speaking, but these investors are better served by firms such as ours where the motivation and the incentives are known, the insights and recommendations have no hidden agenda and where the ability and discretion of traders is their raison d’être.

In the days before it became politically incorrect, Goldman Sachs viewed themselves as a gigantic hedge fund. Now they speak of their role as “doing God’s work,” as Goldman’s Mr. Lloyd Blankfein once stated. But they were hedge funds and largely still are. Unfortunately they give legitimate hedge funds a bad name. Real hedge funds serve multiple useful purposes. Markets are more efficient because of them. They provide an opportunity for wealthy investors who are willing to assume more risk for the prospect of higher returns. They identify and highlight corrupt managements, dishonest accounting practices and over-priced securities. They tend to attract very bright and highly skilled men and women. But private hedge funds are not using depositors’ money to make those bets, nor are they using shareholders money. They are investing theirs and their limited partners’ money. With the notable exception of Long Term Capital in 1998, when they fail government (the taxpayer) does not step in to bail them out.

In the late 1960s, a few years after Andy started the firm, John Whitehead, then co-head of Goldman Sachs, issued twelve principles for employee behavior. At the top of the list was: “Our clients’ interests always come first.” We have never felt the need to issue a similar set of principles. After so many years it has become ingrained in our DNA. In betting against their clients, Goldman partners have been richly rewarded. In today’s culture, the ends justify the means. However, it is indeed unfortunate to the investing public and to taxpayers generally that Goldman no longer adheres to Mr. Whitehead’s first principle.

Thursday, May 26, 2011

The world is a dangerous place. It always has been, but it was the development of nuclear weapons in the last weeks of World War II that provided an extra dimension to that danger. During the Cold War, as school children in the late 1940s and early 1950s, we were (ridiculously) made to hide under our desks during drills and some of our parents built bomb shelters. However, reality was that the U.S. and the Soviet Union dominated and generally controlled their respective spheres of influence. During those years when nuclear weapons were new and feared; the threat of mutual assured destruction (MAD) allowed for a fragile peace – the Cold war – broken by hot wars in Korea and Vietnam.

With the collapse of the Soviet Union, unilateral power descended on the United States. The consequence was somewhat anarchical in that rogue states like North Korea, Syria, Iraq and Iran no longer had the controlling influence of Moscow. Into this chaotic world, nuclear weapons appeared in countries like Pakistan and North Korea. Risk became elevated, (though children no longer have to hide under their desks!) Countries like Iraq and Syria sought such weapons, but thanks to Israel their wishes turned to ashes. It increasingly appears, though, that Iran will become a nuclear power, unless the Israelis once again become the world’s thankless savior.

But where the risk may be the greatest is in Pakistan. India and Pakistan have fought on and off since partition. The Taliban in Afghanistan have long wanted to dismantle Pakistan’s government. In a phone interview with the Wall Street Journal, Pakistan Taliban spokesman Ehsanullah Ehsan admitted that the Taliban’s intention is to “take over Pakistan and its weapons.” The government’s hold on power can best be described as tenuous – the army and the country’s premier security operations, the ISI, seemingly operate independently from Islamabad. And, of course, India lurks menacingly. In terms of population, Pakistan is the sixth largest country in the world. However, it ranks 136th in terms of GDP per capita. According to the IMF, GDP per capita is $2,791, placing the country behind Uzbekistan, Nicaragua and India. In fact, India’s GDP per capita is 20% higher than Pakistan’s.

Pakistan is a nuclear power, having conducted their first tests in 1998, in response to tests conducted by India a few weeks earlier. Pakistan, along with India and North Korea, has never signed the Nuclear Non-Proliferation Treaty. It is estimated that they have between 90 and 110 active warheads. Most of their weapons are hidden in undisclosed locations. To keep them out of reach from possible Indian airstrikes they are presumably sited along Pakistan’s western borders, the area, ironically, most vulnerable to terrorist incursions from Afghanistan. The “father” of Pakistan’s nuclear program, Abdul Qadeer Khan, in 2004 confessed to heading an international black market ring involved in selling nuclear weapons technology. While he denied complicity by the Pakistani government or army, his denials have been questioned. Two years ago he was released after spending five years under house arrest.

Two recent incidents have added fuel to what is already an incendiary situation. On Sunday a team of Jihadists stormed a naval aviation base in Karachi on the Arabian Sea. Details have been sketchy, but estimates suggest that between six and twenty militants were able to make their way into a high-security facility and destroy two naval aircraft. After seventeen hours the base was secured by Pakistani security forces. The attack was apparently in retaliation to the Americans killing of Osama bin Laden. But it served to remind the world of the vulnerability of supposedly secure military locations in Pakistan.

And then on Monday, American-Pakistani terrorist, David Headley testified in a Chicago court that Pakistan’s ISI (Inter-Services Intelligence Agency) was behind the November 26, 2008 bombings in Mumbai. Discovering proof that ISI, Pakistan’s official security force, was involved in the deadly attacks in Mumbai served to confirm India’s suspicions, elevating an already tense situation.

The Taliban, with al Qaeda and their Jihadists terrorists’ allies, would like to see Pakistan and Afghanistan become one large “Talibanistan.” According to Stratfor, the Taliban look upon the United States as critical to achieving this goal. Stratfor’s theory is that the unprecedented unilateral action taken by American forces to kill Osama bin Laden has increased the unpopularity of the U.S. within Pakistan, making it more difficult for the central government in Islamabad to deal with the U.S. as an ally. The Taliban may have killed thousands of Pakistanis, but they also argue that they are their country’s protector against intrusive Americans.

The bottom line is that Pakistan suffers from immense poverty, which helps sow the seeds of self destruction. As hope dwindles, the fear of survival can be assuaged by the promise of martyrdom, of forty virgins, of life everlasting. It is a chilling prospect, perhaps not probable, but also not impossible. The country’s government is highly unstable, but nevertheless it is one in which control and command of nuclear weapons is critical. We and most of the rest of the world have an interest in a stable Pakistan, but how do we achieve that when so many are aligned against us? It is a country in which most of the people have no “skin in the game,” thus the fear of MAD has less meaning. The best hope is an increase in living standards, a fond but, over the foreseeable future, futile wish. In the meantime it is a risky place in a dangerous world.

Wednesday, May 25, 2011

Europe has become a focus of attention principally because of the political and financial instability in the region, an instability driven by nations falling into one of two camps – the parsimonious or the profligate. However, there are other developments worth watching, one of which has the potential to be consequential, and that was a decision last week by the Visegrad Group (V4) to form a “battle group.” Last week George Friedman wrote in Stratfor: “The obscurity of the decision to most people outside the region should not be allowed to obscure its importance.”

The V4 is comprised of four countries: The Czech Republic, Hungary, Poland and Slovakia. All are current members of the European Union; Slovakia is a Euro Zone member. All four are members of NATO and, naturally, all were members of the Warsaw Pact prior to its dissolution in early 1991.

The four countries, comprising a part of what is termed New Europe; sit between two historic enemies of each other and of the region – Russia and Germany. The history of the pact has its origins in 1335 when the leaders of Bohemia , Hungary and Poland met at Visegrád Castle in Hungary. They agreed to create new commercial routes, as a means of bypassing Vienna and to obtain easier access to Western European markets. After the fall of the Soviet Union, the three countries – then Czechoslovakia, Hungary and Poland – met on February 15, 1991 in the town of Visegrád and formed the Visegrad Group as a means of promoting their specific interests.

As a stand-alone group, the Visegrad Group has the fourth largest population in Europe (22nd in the world) and Europe’s seven largest economy (13th in the world.) Its original purpose in 1991 was to create a regional framework, with the purpose of joining the European Union and NATO.

The battle group would be placed under the command of a Polish general. It would be in place by 2016, as an independent force that would not be under NATO command. However, beginning in 2013 the four member countries would begin joint military exercises under the auspices of the NATO Response Force.

Factors that prompted the decision include:

A) Fear of the growing power and reach of Russia.

B) A perception of a developing weakness regarding a unified Europe.

C) Recognition of a fragmenting NATO.

Poland, the largest of the four members, borders both Germany and Russia and in the past 75 years has been occupied by both. As a buffer between the two, they realize they would be in the vanguard of a push from either direction. Russia under Putin and then Medvedev, over the past ten or fifteen years, has overthrown the conciliatory posture of Boris Yeltsin. The country has taken on a more aggressive attitude toward “influencing” its former satellites. Georgia was successfully invaded in August 2008. Friedman suggests the year 2008 may well mark the end of the first stage of the post Cold War era. Germany’s warming relations with Russia – a need for Russia’s energy and a need by Russia for Germany’s capital – send chills through Central European states. These countries, which spent forty-five years enslaved within the Soviet sphere have less confidence than we in the West do that the Cold War is only a memory.

A Europe increasingly split between the north (ex Ireland) and the south – between creditors and debtors – has lessened conviction of the long term sustainability of the union. They question Germany and France’s motivation in the recent crisis. Are they acting in the interests of a unified Europe, or are they protecting there own financial institutions? Europe, according to this analysis, has lost some of its allure.

The Libyan conflict has demonstrated a fragmentation between the France, Britain and Italy on one side and Germany on the other. How certain can the Visegrad Group be that NATO would come to their defense should the need arise? The United States, under pressure from Russia, has backed away from installing a missile defense system along Poland’s eastern border. America has pledged one brigade (about 5000 soldiers) to the defense of Poland, in the event of a conflict. (Russia, in 2007, had an army of 1,200,000 troops, with reserves of another 754,000.) Libya has also shown that NATO, absent U.S. leadership, is generally ineffectual. Here is an organization consisting of twenty-eight members including the U.S., in its 10th week of air attacks, authorized by the U.N. that has proven incapable of unseating the dictator of a country of 6.4 million people, a country geographically the size of Alaska, with an army of 50,000, including reserves.

Forming a battle group for their own defense was surely not a consideration when twenty-years ago these countries emerged from the yoke of Communism. The decision to do so must have been anguished, and it means valuable resources will have to be diverted from economically more productive venues. However, they felt it was necessary to act. The V4 will likely look south toward the Black Sea and north toward the Baltics for partners and allies. They may well ally themselves with other battle groups, for example the Balkan Battle Group (Greece, Bulgaria, Cyprus, Slovenia & Romania) and/or the Nordic Battle Group (Sweden, Finland, Estonia, Norway & Ireland.)

War may not be the natural state of man, as Thomas Hobbes asserted almost 400 years ago. It does, though, reflect cultural differences – religion being the most important, but also factors such as trade and geography. Self interest governs states, and immutable differences have been resolved by conflict over thousands of years. We would like to believe that war in Europe is impossible; however, in the decade and a half before 1914, most observers of Europe did not predict the unbelievable slaughter that would become their fate.

At a time when America’s focus is dissecting the special election in New York’s 26th Congressional District and Europeans are attempting to thwart what seems like an eventual restructuring of Greek debt, these events in distant Central Europe may seem like small beer. “However,” as George Friedman writes, “sometimes it is necessary to recognize things that are not yet significant, but will be in ten years.” This could be one of those times. The Visegrad Battle Group bears watching.

Tuesday, May 24, 2011

Most Democrats in this country, like their Socialist brethren in Europe, profess themselves liberals; they claim to represent the interests of the poor and disenfranchised. The truth is more complicated. Despite the fact that the partners of Goldman Sachs provided twice as much money to Barack Obama’s campaign as they did to John McCain’s in 2008, Republicans are skewered by Democrats and the press as lackeys of the monied classes. Democrats represent the leadership of large unions, who themselves are increasingly distanced from the people they supposedly represent. Too many Democrats are not small “d” democrats. President Obama’s decision to side with the teachers unions in Washington, D.C., in the issue of vouchers, against the wishes of poor black families is one instance. The decision by the Administration to support the International Association of Machinists and Aerospace Workers in their bid to prevent Boeing from opening a second assembly line for the 787 Dreamliner is another. Not only was the move highhanded, it reflected arrogance and a contemptuous disregard for the non-union workers in South Carolina.

In his speech on the Middle East on May 19 at the State Department, there was a whiff of Saul Alinsky in President Obama’s speech when he said, “…after decades of accepting the world as it is in the region, we have a chance to pursue the world as it should be.” As it should be? In whose opinion?

Last December Charles Rangel was censured by the House for misconduct, including failure to pay taxes on income he had not reported. At the time, he was chairman of the House Ways and Means Committee, which writes tax legislation. Mr. Rangel was questioned by a Washington Times reporter, following the censure vote; the reporter asked if the average American citizen had committed a similar felony would he be treated more harshly? Mr. Rangel’s response was: “I don’t deal in average American citizens.” Too bad. If he did, he would never have engaged in such nefarious activities.

Elizabeth Warren, who hopes to be confirmed as the White House’s latest Czarina as head of the Consumer Financial Protection Bureau, stated last week that “we will build a strong enforcement arm.” Banks, under her guidelines, would be subject to twenty new reporting mandates, with inner city activists (community organizers?) having a say on credit grants, thereby raising the risks for banks. Borrowers – and perhaps taxpayers – will have to pay for the likelihood of increased write-offs. A thousand banks, according to estimates, are expected to fail, as the cost of compliance will impair their margins. The consequence will be more limited access to credit for smaller and mid-size businesses and higher interest costs for those that can find the funds. Banks too big to fail will become even bigger; they risk reaching a size of being too big to save. (Of course by then Ms. Warren will have vacated her office, leaving any problems to a future administration.)

Katherine Sebelius, Secretary of Health and Human Services immodestly and immoderately claimed that Representative Paul Ryan’s proposal to address the looming Medicare crisis, while not proposing one of her own, as being a plan that would “cause some seniors to die sooner.” She, of course, said nothing regarding the clause in Affordable Care Act that removes $500 billion from Medicare, in order to make Obamacare “affordable.”

While on the subject of Mr. Ryan, the ad that Democrats have been running showing a Paul Ryan look-alike wheeling an elderly grandmother off a cliff is the most distasteful (and dishonest) political ad since the one run during the Lyndon Johnson campaign in 1964, which showed a young girl sitting in a field amid beautiful flowers. The scene ends in a mushroom cloud with a warning of the risks of electing Barry Goldwater.

President Obama, in his “teleprompted” speeches, has a tendency to use “my” and “I” more than any recent President. He is quick to assign blame and, to the best of my knowledge, has never uttered a mea culpa. He alienated America’s longest standing ally when he returned the bust of Churchill on February 13, 2009 and last week he upset the one real democracy in the Middle East – Israel. High gas prices are blamed on “evil” oil companies and have nothing to do with the domestic supply he has constrained. He wants to tax them more, failing to acknowledge that corporate tax increases are always passed on to consumers.

Syrian President Bashar al-Assad has killed an estimated 1000 demonstrators since calls for reform began in March, and then another twenty at a funeral last week for some of the victims. Nevertheless, President Obama, in a speech last Thursday, said that Mr. Assad still had a choice: “He can lead that transition, or get out of the way.” A thousand protestors killed, and Assad still has a choice? Without giving him credit, Mr. Obama parroted Mr. Bush’s “Freedom Agenda.” Instead, he credited himself: “And that’s why two years ago in Cairo, I began to broaden our engagement…” But unless he starts leading from the front, “Arab Springs” are destined to become long, hot summers. As George Friedman of Stratfor has written: “All demonstrations are not revolutions. All revolutions are not democratic revolutions. All democratic revolutions do not lead to constitutional democracy.”

European liberals are far less liberal than their counterparts in America. The reaction in Europe to Dominique Strauss-Kahn’s alleged run-in with an immigrant African maid in New York demonstrates a supercilious hubris that treats the maid as a non person. Jean Daniel, editor of Le Nouvel Observateur was quoted by Mark Steyn over the weekend: “We and the Americans do not belong to the same civilization.” The police, M. Daniel wrote, should have known that M. Strauss-Kahn was “not like other men.” Jean Daniel could not understand why “this chambermaid was regarded as worthy and beyond any suspicion.” M. Daniel must be right. We cannot belong to the same civilization. I am not sure that the Marquis de Lafayette would admit to being a Frenchman today.

The French liberal intellectual, Bernard-Henri Levy, in defending Dominique, speaks of everything M. Strauss-Kahn has done at the IMF to help the world “avoid the worst.” He says that the IMF has worked to help “the most fragile and proletarian nations.” However, the IMF last year spent a third of their funds helping to salvage French and German banks who own a large portion of PIIGS’s debt. That sounds self-serving, which is okay with me, but why not say so?

It is the hypocrisy that is so obnoxious. Ninety percent of all politicians are bloviating blowhards; they are masters of saying what they believe their listeners want to hear – think of Mr. Obama’s attempt at redemption in his speech last weekend to AIPAC. While I have problems with the social conservative element of the Republican Party, there is nothing quite as off-putting as the arrogant “liberal” who is disdainful of the very people he or she purports to represent. It is little wonder that politicians rank below used car salesmen in terms of respect.

Monday, May 23, 2011

Today’s world-wide market weakness reflects the decision by S&P to reduce Italy’s outlook to negative and a reaction to the Spanish elections, in which the ruling Socialist Party suffered their worst defeat in thirty years. However, looking at markets through a wider scope, commodities and Treasuries have done well over the past decade with the yield on the 10-Year falling from 6.6% at the start of the decade to 3.15% today. So, is it time to switch the emphasis from income consuming assets (commodities, antiques, art, and collectibles) to stocks, an income producing asset? The question is perhaps too simplistic, as there are enormous differences, not just between but within asset classes. Nevertheless, it is worth considering.

The point about income consuming assets, as Warren Buffett has noted, is that the only way an owner makes money is when somebody proves willing to pay more than you paid – a dependency on what is sometimes called the “Greater Fool.” A painting hanging on the wall takes up space. A diamond bracelet or a gold coin spends most of its life in a safe. A rare book is squeezed between two others. Oil, like a good meal, is consumed and then is gone forever. In contrast, an income producing asset provides dividends or interest and the prospect of growing earnings and expanding its book value. With that opportunity comes risk. Management may commit fraud or, through incompetence, shrink the company’s earnings. There is also the risk that one pays too much for the business, and there are exogenous risks over which one has no control. Commodities are also subject to exogenic factors and the risk of price. Have you, the buyer, become the greater fool? It is difficult to determine how much of the price of a commodity reflects underlying demand and how much represents speculation.

Two factors fueled the boom in commodities over the past ten years. One was the growth of the emerging world, a development that should persist, albeit with periodic and temporary setbacks. The second was a function of the Federal Reserve. In the wake of the stock market collapse in 2000-2001, the Fed began reducing the Fed Funds rate from 6.5% at the end of 2000 to 3.5% by the end of August 2001. In the wake of 9/11 and the mild, stock market-slump induced recession in 2001, the Fed overreacted and continued lowering Fed Funds until they reached one percent in June 2003. They remained at that level until the following June, in spite of the fact the recession had ended three years earlier, and the stock market bottomed in October 2002. By June of 2006, rates were back to 5.25%, but the damage (in terms of housing) had been done. The low cost of money encouraged households to take on enormous amounts of leverage. Wall Street and mortgage brokers were willing to oblige.

The Fed was slow to dampen the speculative fervor that coursed through the economy in the mid 2000s and they were slow in responding to the credit crisis in mid 2007. While the Discount rate was lowered in a special meeting in August of that year, it was September before the Fed lowered the Funds rate twenty-five basis points to 4.75%. And it wasn’t until December 2008 (after the worst of the credit crisis was behind us) that the rate was lowered to today’s level of 0.25%. The minutes from the most recent meeting suggest that they are conscious of the possibility of rising inflation, but those minutes also imply they are in no rush to change direction. To assume the Fed will get it right this time is to bet against history.

In the late 1990s, as the last century was coming to a close, the price of oil was $17.00 per barrel, gold was selling at $279.00 an ounce and the S&P 500 closed the year 1999 at 1469.25. Now, more than eleven years later, gold has risen 5.4 times, oil 5.7 times and the S&P 500 is 10.9% lower. The decade of the 2000s was the mirror image of the 1990s.

The end of the 1990s culminated with a spectacular, speculative demand for internet-tech stocks. The NASDAQ 100 had risen more than sixteen fold in the previous ten years to 4816.35; its high-water mark, reached in March 2000, was 10.5% above where it is today! During the 1990s, the S&P 500 rose from 366 to 1525, an increase of more than fourfold. By the time the party came to an end, the multiple on the S&P 500 was thirty-five times peak earnings. During that decade (the 1990s), gold fell from $391.00 to $279.00, while oil fell from $27.00 to $17.00. Both commodities had fallen in price during the 1980s – gold from $800.00 to $379.00 and oil from $35.00 to $27.00.

The rate of inflation has been moderating for forty years and bonds, for three decades, have risen in consequence. During the 1970s, the CPI rose 112%; its rate of increase declined to 59% in the 1980s, then 32% in the 1990s and 27% in the 2000s. One of the many conundrums facing investors is: will this trend continue, or have we reached an inflection point? The fact that leverage has swung from corporations and consumers to government suggests that the risk of a depreciating dollar (and a concomitant rise in inflation) has increased. We should never forget that government controls the printing presses. Why would government pay the Chinese (or the Federal Reserve, for that matter) expensive dollars when it can repay in depreciated dollars?

The last four decades have been extraordinary. The next one will have its own characteristics. Commodities dominated the 1970s; bonds and stocks the ‘80s and ‘90s. Commodities roared back in the 2000s. Is it time for stocks again? No one knows for sure. The great bull market that began in 1982 and ended in 2000 was driven by a combination of factors, none of which exist today: single digit multiples of earnings at the start of the rally; declining interest rates and inflation; long years of tax reductions, and a business-friendly regulatory environment. Today, earnings multiples are double what they were in 1982, interest rates and inflation are more likely to rise than not, the regulatory environment is getting tougher, not easier, and taxes are certain to be raised should Mr. Obama win re-election, which, given Republican disarray, seems probable.

However, money must flow somewhere. Decisions, unfortunately, must be made without the benefit of hindsight. Nevertheless, expectations, in my opinion, should be for modest returns. Cash, even with no return, is a valid option, as it provides the chance to take advantage of inevitable and unpredictable opportunities.

The forty-year compounded return price return to the S&P 500 has been 6.8%, roughly the very long term average. Gold, from its frozen position of $35 an ounce prior to the summer of 1972, has risen at a compounded annual rate of 10% and as we know, it cannot be drunk or eaten and does not generate income. The prospect that a 3.2% return on a Ten-Year Treasury will offset inflation seems dubious. So, if asked today to make the choice between owning $1 million worth of gold, $1 million worth of Treasury Bonds, or $1 million of a portfolio of stocks selling less than ten times earnings, with a history of improved earnings and with nominal yields, I would answer, stocks. Keep in mind, though, the environment is very different than it was in 1982.

Thursday, May 19, 2011

“When it becomes serious, you have to lie;” so said Jean-Claude Juncker, Prime Minister of Luxembourg, the longest standing head of government in the democratic world. He is also the President of the Eurogroup, a collection of the Eurozone’s finance ministers.

What prompted the arrogant outburst from the pompous M. Juncker were press reports a few days ago that Greece was considering alternatives, including default. European officials are considering requesting more collateral, as they attempt to contain Greece’s plight. European Central bank chief, (the other Jean-Claude,) M. Trichet has said a restructuring is not on the table. M. Juncker said that he does believe further adjustments are necessary, but that, “We’re not discussing the exit of Greece from the Euro area. That is a stupid idea – no way.” Of course, he then added that he is willing to lie; so, what are his intentions? The bond market seems to have decided a restructuring is likely.

Mark Twain would have taken satisfaction in M. Juncker’s announcement; Mr. Twain once claimed that “a man is never more truthful than when he acknowledges himself a liar.” But a politician, or anyone for that matter, having once admitted being a prevaricator, loses all credibility. Of course it is assumed and expected that all politicians lie; ergo the syllogism:

All politicians lie.

I am a politician.

Therefore, I am a liar.

As contemptuous of the electorate as was M. Juncker’s outburst, M. Trichet was equally disingenuous when he added (about Greece,) “We have a program, approved by the international community, approved by the IMF board (obviously now subject to change,) by the entire world, approved by the European Union and financed by the IMF and the European Union.” However, twixt the cup and the lip something slipped. Rates on 2-Year Greek Notes jumped from 12% to 24%. No one may be lying, but someone is not telling the truth.

Debt is overwhelming nations like Greece, Ireland and Portugal. Italy and Spain are also suspect. The problem has been one of feasting on social programs that have enhanced living styles at the expense of savings. Indigestion usually follows such gluttonous excess. Not wanting to take the write-downs, creditor nations desire time, not stomach pumps. As a reporter for “Mish’s Global Trend Analysis” put it, “they have been using band-aids when an amputation is needed.” Greece, Ireland and Portugal, according to a recent Bloomberg report, have been given $366 billion in emergency funds thus far, yet their debt situations continue to worsen. The combined debt of the three countries is expected to reach $1 trillion in 2012 – much of which is held in banks of creditor nations Germany and France – versus $800 billion in combined GDP.

George Papandreou, the Greek Prime Minister, insists his country will not abandon the Euro. “These are groundless reports, provocations put out by irresponsible people aimed at speculation, at profiteering.” He claims that these “wild scenarios” are negative for everyone, the Greek public and for those foreign interests who want to invest in Greece. If he were Pinocchio, his nose would be a foot long. The public is not served by trekking through this Purgatory, not knowing how much of their country’s assets will have to be pledged to German banks. How many investors are anxious to invest in a country that has lost control of its finances, the leader of which seems more concerned with the legal niceties of its creditors than in the interests of its people? Defaulting on one’s debts is not the worst that can happen. In the personal and corporate world and, in fact, in the world of sovereign nations defaults often make sense – an opportunity to start fresh. In 1998, Russia devalued the Ruble and restructured their debt; yet within a few years the country was back in markets borrowing at record low interest rate levels. In financial markets, there is life after death.

European elites have long looked down their long noses at their crude, upstart cousins across the seas. America has long had the unique advantage of being reinvented every generation, as immigrants add to our culture. As a country, we have inspired and supported individual initiative and creative independence.

Yet the lessons of fatuous Europe have been ignored by too many gullible Americans – perhaps not gullible, just desirous of being loved. The failed social democracy experiments in places like Greece are being emulated by those in Washington who would increase the dependency of the electorate at the expense of individual initiative. In the immediate postwar years, people on both sides of the Atlantic were intent on restoring their lives and rebuilding their economies. In Europe, following thirty years of war, an implicit pledge to remain at peace was omnipresent. But sometime in the 1960s, as James Q. Wilson (professor and author of A Moral Sense) once said, “Self control gave way to self expression.” One’s focus on the future bowed to self-satisfaction today. That behavioral change was mirrored in our governments.

In the U.S., we are headed down the same path, toward the same gate through which is the abyss of overwhelming debt, of living beyond our means. (That is the enticement and the danger of Obamacare.) In abandoning his fellow members on the “gang of six”, Tom Coburn yesterday said that no matter what decision is now made regarding Social Security, Medicare and Medicaid – including no decision – they will look different in five or ten years. We can try to fix them now, or we can wait and have them fix us.

Congress and the Administration are caught up in the politics of the moment; no one is willing to be the bearer of bad news. Instead they lie. The cause of our debt situation is indisputable – we are promised what cannot be delivered. Should the economy continue to recover, tax receipts may surprise positively, but the respite will be only temporary. The most likely consequence of government’s profligacy will be dollar depreciation – inflation.

When things get serious, we don’t want lies. We want and we need the truth. In my opinion, the public (at least the American people) is better able to handle the truth of bad news than politicians are capable of uttering it.

Wednesday, May 18, 2011

May 18, 2011
Free trade agreements with South Korea, Colombia and Panama appear to have been sacrificed on the altar of politics. On Monday the White House said it would not seek Congressional approval, as the New York Times put it, “…until Republicans agree to expand assistance for American workers who might lose jobs as a result.” (Italics mine.) The hold up is over an expansion of the Trade Adjustment Agreement (TAA) program that expired last February. The TAA is a program designed to provide training and assistance to those whose jobs have been displaced because of foreign competition. Two years ago, as apart of President Obama’s stimulus package, the program was expanded. It is this expansion that has become the source of conflict.

Thus, the question facing Congress is one of measuring the costs of the expanded program versus the jobs and dollar revenues that would be created with an expansion of trade. Prior to the expansion of the TAA, annual cost estimates were about $800 million. Against those costs (and ignoring the costs of the plan’s expansion,) about 380,000 jobs would be added and increased revenues from exports would be in the range of $10-12 billion.

Increasing employment should be the number one goal of Congress and the President, and these free trade agreements would add jobs. In January 2009, five months before the recession officially ended, there were 11.6 million unemployed in the U.S. The unemployment rate was 7.6%. Today, twenty-six months later and almost two years into the official economic recovery, there are 13.7 million unemployed and the unemployment rate is 9.0%. If increasing exports adds to GDP and increases net employment, the decision to approve these trade pacts would seem obvious. It is unfortunate that some workers will be displaced, but permitting unions to dictate policy that benefits the few at the expense of the many seems foolish. The U.S. labor market is extremely dynamic. According to Robert Nichols, President and COO of Financial Services Forum, the U.S. economy in 2007 created 30 million jobs, while losing 29 million – in other words, about one quarter of all jobs in the U.S. terminate every year and about the same number are created!

Nevertheless, there is no question that providing assistance and training to those who lose their jobs because of specific governmental actions should be the responsibility of that government. The Trade Adjustment Agreement program was authorized under the Trade Expansion Act of 1962. It was formed at a time when President Kennedy was interested in expanding free trade. He said at the time: “When considerations of national policy make it desirable to avoid higher tariffs, those injured by that competition should not be required to bear the full brunt of the impact. Rather, the burden of economic adjustment should be borne, in part, by the federal government.” The statement still holds, but it must be balanced against costs and incentives.

The “expanded” TAA program in 2009 provided idled workers a total of 156 weeks of “income support.” That is in addition to existing retraining programs and the 99 weeks of unemployment benefits available to all who lose their jobs. There is a fine line between providing needed necessary help and providing disincentives to seek new jobs. Five years seems a long time to pay someone for looking for a new job, even if government created the vacuum. Welfare reform, a popular program in the 1990s, addressed similar concerns by adding a workforce development component to welfare legislation, encouraging employment among the poor. The Bill (the Personal Responsibility and Work Opportunity Reconciliation Act of 1996) was introduced by the Republican Congress and signed into law in 1996 by President Clinton, fulfilling his promise to “end welfare as we know it.” Something similar should be a focus of the Administration, as it applies to the TAA program.

It seems odd that this turnabout on the part of Mr. Obama, in backing away from these three free trade agreements, happened at this moment – so suddenly and without warning. On April 7th, a month and a half after Congress repudiated the expansion of the TAA, President Obama referred to the agreement with Colombia as a “win-win” victory. Three weeks later, on April 28th, Mr. Obama commended Panama’s President for his leadership in resolving issues that had stalled the free trade agreement with that country. It’s hard not to conclude that unions, emboldened by the NLRB decision, enjoining Boeing from establishing an assembly line in South Carolina, decided to play hardball with the President.

The advantages of expanded free trade certainly outweigh the disadvantages. Unfortunately in a dynamic economy, especially one that has become increasingly global, there is no way to treat all parties equally. The government has a responsibility to provide equal opportunity to all, but it cannot (and should not) guarantee equal outcomes. There is much that government can do in terms of education and much that they should do in terms of immigration, but to deny the global competitiveness of the world in which we live – to deny businesses and farmers from potential markets and to disallow consumers from less expensive and more varied goods – is to move backward, not forward.

Unions served a valuable purpose, as our country was industrializing; they were instrumental in establishing fair rules, in providing a living wage and elevating workers from the desperate conditions of their workplace. They created the means, via pension funds, that allowed workers to share in the wealth they helped create. However, things have changed. Union bosses are using their clout to maintain relevance in a rapidly changing world. They have become the single largest provider of funds to either political party. They have encouraged the elimination of secret ballots. They are attempting to deny the right to work to the 90% of the labor force who have chosen not to join their unions. The world has moved on, and they have remained mired in the past. What remains is a symbiotic relationship between union leaders and the leadership of the Democratic Party – the effect is damaging to an economy that is facing increased global competition. The setback on the free trade agreements is only the latest example.

Tuesday, May 17, 2011

That America’s entitlement programs have created an untenable debt situation is well known. That officials have known that January 1, 2011 would be the first day that the baby boomer generation would reach retirement age has been known for at least forty-seven years, when the last baby boomer was born in 1964. Every President since Gerald Ford has been apprised of the consequences of ignoring the distant rumbling of this avalanche. All have chosen to ignore its warnings.

The Trustees report on the status of Social Security and Medicare issued last Friday suggests the day of reckoning cannot be put off much longer. Perhaps it won’t. President Obama created a deficit commission, whose findings he chose to ignore when he presented his initial 2012 budget in February. But that commission’s report is now in the hands of the “gang of six” whose report and recommendations are due out shortly from Congress. Only Representative Paul Ryan has been willing to face the problem head on, and he has been shunned by several of his fellow Republicans who find the prospect of dealing with entitlements potentially hazardous to their re-election prospects.

Standard & Poor’s recently changed their outlook for U.S. Treasury debt from stable to negative. Typically, bond vigilantes would be all over this situation, driving Treasury interest costs substantially higher. Instead Treasuries have rallied since that April date, with the yield on the 10-Year declining about 6% to 3.15%. One reason: the Federal Reserve, as part of its quantitative easing programs, has become the largest buyers of Treasuries. “It’s not a free market,” Stan Druckenmiller was quoted as saying in an interview in Saturday’s Wall Street Journal. “It’s not a clean market. The market isn’t saying anything about the future. It’s saying there’s a phony buyer of $19 billion of Treasuries a week.”

And, of course, all revenues from Social Security and Medicare are invested in U.S. Government notes and bonds. As of yearend 2010, the combined assets of Medicare and Social Security amounted to $2.953 trillion, or about 20.6% of all U.S. debt. QE2 is scheduled to cease in June; Medicare, according to the Trustees Summary Report, had net outflows in 2010 of $36.8 billion. Social Security still had net inflows of $68.6 billion, but the handwriting is on the wall. Having been buyers of Treasuries, these deep-pocketed entities are close to becoming liquidators.

Perhaps the markets are saying that, finally, Washington will get serious about spending – that the catalyst of the debt ceiling flap on top of a depressing report from the Trustees of Social Security and Medicare (that includes the Secretaries of Treasury, Labor and Health & Human Services) and a deficit of record proportions will be enough to cause Congress and the Administration to respond with common sense. Perhaps? As Hamlet might have said, “Tis a consummation devoutly to be wished.”

Nevertheless, the complacency in Treasuries today reminds me of that eerie apathy in the mortgage market in late 2006 and early 2007. On February 26, 2007, I quoted Martin Eakes who was (and is) CEO of the Center for Responsible Lending in North Carolina on the subprime market at that time: “…a quiet but devastating disaster.” Today, the Trustees’ report highlights the problems being faced by both Medicare and Social Security. Aggravating today’s situation is the debt ceiling which is rapidly approaching. It has become a political football, with Republicans using it as a means of addressing spending. Democrats are trying to scare the bejesus out of people, as to the consequences of a technical default, Treasury Secretary, Geithner warned of a “catastrophic economic impact.” Last week Federal reserve Chairman Ben Bernanke suggested, if the debt ceiling is not raised, the markets would experience a crisis similar to the one that followed the Lehman bankruptcy in 2008.

But raising the debt ceiling without addressing spending would be more irresponsible, with consequences far direr than a technical default on Treasuries. In his interview with the Journal’s James Freeman, Mr. Druckenmiller said that markets know the difference between a default in which a country will not repay its debts and a technical default, in which investors may have to wait a short period for a particular interest payment. If we continue down the path we have been on, we risk falling into the former category six or seven years down the road – of becoming Greece. There is not a lot of time. The future, as the saying goes, is now.

Nobody likes to be the bearer of bad news, especially politicians whose next meal is dependent on winning the next election. Acknowledging that reality, toward the end of the Summary Report, trustees Charles P. Blahous III and Robert D. Reischauer write: “Reluctance to resolve the Social Security and Medicare shortfalls is understandable, as doing so involves slowing the growth of program benefits, increasing the age at which individuals become eligible for benefits, or increasing the taxes and premiums that support these programs.” None of which is typical grist for a politician’s mill. But it is my guess that the people are smart enough to know that trees don’t grow to the sky and that money for nothing is not an alternative. Paul Ryan’s ideas may not be dead.

The problems are “good” ones, in the sense that they are products of improvements in healthcare and the fact that life expectancy has been extended. There are solutions that are pretty straightforward, if only politicians, apart from Mr. Ryan (who has now been thrown under the bus by the intellectually peripatetic Newt Gingrich,) would dare confront them: extend the retirement age; provide a “means” test for Social Security; raise deductibles on Medicare, based on income or wealth; increase insurance competition, allowing companies to compete across state borders, and implement tort reform.

Of course there is possibly a more simple solution. Should Sarah Palin’s concern that death panels prove to be a reality of ObamaCare, long term demands on both Social Security and Medicare will vanish. Problem solved.

Monday, May 16, 2011

From what I have read and have heard, it appears that the jury had no other choice than to offer a verdict of guilty in the case against Raj Rajaratnam. Justice, as our President might say, has been served – or will be, assuming the 2nd Court of Appeals upholds the Manhattan Federal Court.

Corruption in any field is wrong and should be punished. I find it particularly (and personally) offensive when it surfaces in the business in which I chose to work forty-four years ago. It is a business that pays especially generously; its participants, for the most part, recognize the good fortune that found them with careers on Wall Street. However, there always will be a few for whom a lot is not enough. “Greed,” as Preet Bharara, United States attorney for the Southern District of New York, said in March, “sometimes is not good.” In fact, I would say greed is never good. Some of you will recall Alexander Pushkin’s story, The Tale of the Fisherman and the Fish, in which the fish, in exchange for his freedom, promised to fulfill any wish the fisherman chose. The fisherman, greed in his eye, released the fish that promptly swam off. The moral is: greed, minus common sense leads to disappointment or worse.

Aspiration, in contrast to greed, is a positive characteristic and a necessary ingredient for success in any endeavor. There are times when the line between the two is difficult to discern. In the unusually competitive world of investment management, quick and accurate information is often the difference between success and failure. There is speculation that the prosecution, fresh from this success, will aggressively go after other hedge funds and so-called expert network firms. While there certainly may be other examples of sources knowingly passing on illicit information, the government (and the press) must keep in mind that Wall Street is all about networking. Analysts are paid handsomely for the information they uncover, for their judgment and for their ability to bring managements to their investing clients.

Reed Brodsky, the attorney who prosecuted the government’s case was quoted in Thursday’s New York Times: “Wall Street is supposed to be an even playing field.” However, it never will be. Small investors will always be disadvantaged relative to their institutional counterparts. Investing is about information and judgment; institutional investors have more access to better information. Jailing thousands of professional investors will not even the odds. In any case, the difficulty of investing is manifested in the underperformance by so many; ergo, the attractiveness of indexing.

The success of the Rajaratnam case was based almost solely on wiretaps allowed by Judge Richard J. Holwell. The FBI taped phone calls into and out of Mr. Rajaratnam’s office over a nine month period in 2008. The judge’s decision last December to admit those wiretaps spelt the doom for the defense. Wiretaps under the Racketeer Influenced Corrupt Organization Act have typically been used against the Mafia, money laundering or narcotics cases. The Rajaratnam case was the first insider trader case that permitted the jury to listen to secretly recorded telephone conversations. In this instance, according to a report on Reuters, the FBI were granted the ability to use wiretaps, as initially they were investigating Galleon Group for wire fraud and money laundering. In the process they ran across evidence of improper trading. According to the same Reuters report, in getting the green light for the wiretaps, the FBI failed to mention that the SEC had been investigating Mr. Rajaratnam for years – an omission the judge called “glaring.” That is likely to be grounds for appeal.

Successful government prosecutors often develop oversized egos and decide to leverage their victories into bigger political opportunities. Rudy Giuliani, as U.S. attorney for the Southern District of New York in the 1980s, became infamous for cuffing his accused and walking them out of their offices in so-called “perp walks.” Among his victims was Richard Wigton of Kidder Peabody; he later was found innocent. Giuliani’s perp walks gave him fame and glory, but deeply harmed the lives of dozens of innocent people like Mr. Wigton. Similarly, in the mid 2000s, N.Y Attorney General Eliot Spitzer went on a spree indiscriminately charging victims, the best known of whom was Maurice “Hank” Greenberg of AIG. Most of those charged, including Mr. Greenberg, were later found innocent. Nevertheless, off of destroyed reputations, Mr. Spitzer catapulted himself into the governor’s seat where he perched, until being hoisted on his own petard.

Preet Bharara appears to be taking a more discrete path. In March, he was quoted as saying that there was “nothing wrong or bad about hedge funds or expert networking firms or aggressive market research for that matter.” His ego seems to be less than that of either Mr. Giuliani or Mr. Spitzer. However, wearing the crown of being Mayor or Governor can be an alluring siren.

Last Thursday, the New York Times wrote about the case: “It is an important step toward restoring trust as a prerequisite of America’s financial markets.” I wish I could agree. Far more relevant, in my opinion, to restoring confidence would be prosecutorial success in addressing the issues that caused the credit collapse in 2008, and, as important, explanations for the “flash crash” last May. The problem, of course, is that any investigation of those two instances will lead, at least in part, directly back to Congress and the regulatory bodies they oversee.

Congress, unfortunately, remains above investigation, but not necessarily above stupidity or corruption, as seems increasingly obvious as more information is uncovered dealing with the events leading up to the credit crisis of 2007-2008. Mark Twain, with his rapier-like wit, often characterized that august body. In his biography, he wrote: “Suppose you were an idiot. And suppose you were a member of Congress. But I repeat myself.” In “Pudd’nhead Wilson’s New Calendar,” he added: “It could probably be shown by facts and figures that there is no distinctly native American criminal class except Congress.”

Winston Churchill once said, “A democracy is the worst from of government except all the others that have been tried.” He also added, sounding somewhat like the elder Mr. Clements, that “…the biggest argument against democracy is a five minute conversation with the average voter.” Democracies are notoriously inefficient. In a world seemingly embalmed in a mist of attention deficit disorder, the wheels of justice grind slowly. But they do grind, and the truth usually outs.

Intelligent and educated, but ethically-challenged money managers, like Raj Rajaratnam, were once described by John Kenneth Galbraith as men “whose genius and imagination are unconstrained by integrity.” In the end, they are simply crooks, deserving of punishment, not for inflicting harm on any particular person (though that may have been a consequence,) but for not playing by the rules that apply to all those who live and compete in civilized society. However, we must also be careful, in our desire and haste to prosecute those whom we believe have broken our laws, that spurious means do not delegitimize the ends.

Thursday, May 12, 2011

No one should be surprised that removing the cookie jar creates tears. But the tantrum being thrown by those model citizens at Goldman Sachs, as plans are being finalized for the implementation of the Volcker Rule, is unbecoming even to the rough and tumble world of Wall Street. The firm has outspent its competitors, by a wide margin, in an attempt to influence the implementation of the Volcker rule. As one lobbyist put it, “They’re totally freaked out about Volcker.”

Paul Volker, former Chairman of the Federal Reserve who slew inflation in the early 1980s, was appointed Chairman of the President’s Economic Recovery Board on February 6, 2009. A year later the Volcker Rule was enunciated. It would prohibit a bank or institution that owns a bank from engaging in proprietary trading that isn’t at the behest of its clients; it would prevent banks from owning or investing in a hedge or private equity fund; and it would limit the liabilities that the largest banks could hold. In the intervening months, in response to lobbyists, Congress and regulators have added amendments that have weakened the proposed rules.

There are five different regulatory bodies (including the Federal Reserve and the S.E.C.) now in the process of writing separate versions of the Volcker Rule. According to Reuters, under the terms of last year’s Dodd-Frank Bill, regulators have until July to come up with specific rules for implementing the Volcker provision. Goldman Sachs has wasted no time (and no money) to influence the rules and the manner in which they would be enforced. They have a lot riding on this issue. Last year proprietary trading contributed about $1.5 billion of their net income of $12.9 billion. In terms of margin contribution, proprietary trading is typically the highest. While Goldman and others argue that it is difficult to separate proprietary trades from customer orders, Mr. Volcker in a recent interview said: “Bankers know when they’re doing a proprietary trade, I assure you. If they don’t know, they shouldn’t be in the business.”

Proprietary trading would be permitted, but limited to Treasuries, GSEs and municipal bonds. Rules regarding derivative contracts have been tightened under Dodd-Frank. Banks like Goldman are lobbying to get currency contracts exempted from derivative regulation. Investments in hedge and private equity funds would be allowed, but limited to 3% of Tier 1 capital (the ratio of a bank’s shareholders equity capital to its risk weighted assets.) Under Basel II, a well-capitalized bank must have a Tier 1 ratio of at least 6%. (Those rules are expected to be tightened when Basel III go into effect in 2012.) The fate of principal transactions (merchant banking operations) is yet unclear.

Bank of America analyst, Guy Moszkowski, was quoted recently in the Huffington Post that Goldman continues to make principal investments (i.e., their $450 million investment in Facebook and a prospective investment in China’s Taikiki Life Insurance Company) because they don’t believe the practice violates the Volcker rule. On the other hand, regulators are conscious of the fact that Lehman Brothers’ participation in the $23.6 billion LBO of Archstone-Smith, a property group, contributed to the firm’s demise in 2007.

Certainly, there is a difference between picking off short term trades for one’s proprietary account and investing capital into fledging businesses. Nevertheless, and regardless of the Volcker rule, banks have a fiduciary responsibility to their depositors and, as managers of publically traded companies they are beholden to their shareholders. The moral hazard lessons created by the (necessary, in my opinion) bailouts in 2008 have, unfortunately, perpetuated a sense of “heads I win; tails I don’t lose.”

In my opinion, the decline in fiduciary responsibility on the part of investment banks began when former partnerships became publicly traded companies. It was aggravated with the annulment of Glass Steagall in April 1998 when Citigroup acquired Travelers (which owned Salomon Smith Barney.) These events marked a return to the risk taking on the part of banks that was more common in the 1920s. Spread banking was (and is) neither as exciting nor as profitable as trading.

Contrary to what the Goldman lobbyists would have one believe, the rules are not aimed at reducing profits at Goldman, though they may have that effect. They are designed to make banks and banking safer. If a financial institution prefers to trade for its own account, it has every right to do so; but not as a bank that has access to cheap capital via the Fed window and which holds individual deposits guaranteed by the FDIC.

Other than filling the pockets of traders and senior management, proprietary trading provides little, if any, economic value. At the same time, as we all know, it can create enormous risk – risk that when emanating from banks that are “too big to fail” is borne by taxpayers and shareholders, not by the perpetrators. There is nothing wrong with individuals, private partnerships or even public companies (when the shareholders are fully informed of the risks) from engaging in such activity; so long as their activity does not endanger our financial system. A recent poll of investors, traders and analysts showed that 54% view Goldman in a poor light, so my comments may be seeing as piling on.

Goldman Sachs, in the fall of 2008 and under duress, became a bank, able to access the Fed window. It should be subject to rules governing commercial banks. It always has the option to reconstitute itself as a partnership, or spin off its proprietary desks. But as it is, it has the best of all possible worlds. It is little wonder Goldman doesn’t want the system to change.

Wednesday, May 11, 2011

“Before long, all Europe, save England, will have one money.” So wrote William Bagehot, editor of The Economist around 1870. At the time, the Latin Monetary Union, which had been forged in 1830 when Belgium gained its independence from the Dutch and adopted the French Franc, was being considered. Over the next several years, Switzerland, Italy, Greece and Bulgaria joined the LMU. In 1865, the Foundation Treaty (legitimizing the LMU) was signed in Paris. Unofficially, the French influence spread to eighteen countries. Unlike today’s Euro, each country maintained its own currency, but they were at parity with each other in terms of conversion into gold or silver. The extraordinary financing needs of World War I, and the lack of flexibility of the LMU, provided its death knell.

During the decade of the 1870s, the Scandinavian Monetary Union was formed between Sweden, Denmark and Norway. They accepted one another’s gold coins as legal tender within their territories. The union survived the dissolution of the union between Sweden and Norway in 1905, but during World War I Sweden abandoned its tie to gold; without fixed exchange rates, free circulation came to an end.

There are numerous other examples of monetary unions ranging from Ancient Greece to colonial America to Africa. The United States did not have a truly common currency until the Civil War when bank regulation distinguished between national and state-level banks. The National Bank Act of 1863 established the Comptroller of the Currency, in the office of the Treasury, and began issuing “Greenbacks” – the Dollar we know today, absent its convertibility to gold.

If the Euro is doomed, it is because countries like Greece, Italy, Portugal, Spain and Ireland did not practice fiscal prudence during the money-easy aughts. During the past decade the advent of the Euro created a situation that permitted the borrowing costs of profligate Greeks to be linked to credit worthiness of parsimonious Germans. As long as economies were growing and liquidity was present, all went well. But when the credit crisis hit and economies went into recession, the flaws in the system became obvious. A restructuring of Greek debt – extending maturities – would be preferable to defaulting on some, or all, of their debt, but still would be a cost to the holders. BNP Paribas analysts on Monday wrote: “The official line that Greece has a liquidity and not a solvency problem is showing its cracks.” The truth is Greece does have a solvency problem. So do Ireland, Portugal and possibly Spain. Mark Weisbrot, the co-director of the Center for Economic and Policy Research, wrote on Monday that the cost of remaining in the Eurozone is likely to involve, “many years of recession, stagnation and high unemployment.”

Illuminating and aggravating the problem, on Monday Standard & Poor cut the ratings on Greek debt from BB- to B. Yields on their Ten-Year bonds reached 16% and over 22% on their Two-Year notes. An inverted yield curve typically portends recession, as the cost of money for investment or consumption becomes prohibitive. As a member of the Eurozone, Greece no longer has the option of devaluing their currency – a traditional path for countries in trouble. Irwin Stelzer, writing in the Weekly Standard, notes that watching events unfold in Europe “is like watching a slow-motion train wreck.” Borrowing money for the purposes of extending the welfare state, as has been the case in many European countries, is a certain route to bankruptcy. (The U.S. should take note.)

In yesterday’s Wall Street Journal, Timo Soini, Chairman of the True Finn Party (the equivalent of the tea Party in the U.S.) in Finland, wrote: “Europe is suffering from the economic gangrene of insolvency – both public and private.” Thus far there has been little acknowledgement – on either side of the Atlantic – that the cure for excessive deficit spending will be painful. There is no easy way out. What these countries need is someone akin to Paul Martin who became Canada’s Finance Minister at the end of 1993. When he assumed the job, according to a profile in Investor’s Business Daily, “roughly $0.36 of every dollar in tax revenues went to pay interest on federal debt…The country was spiraling.” Three years later the country was in surplus. Mr. Martin had three guiding principals; they are not rocket science:

1) A focus on cutting spending, not raising taxes – $7.00 in cuts for every $1.00 increase in revenues.

2) A focus on short term goals. “They are the most effective – they keep your feet to the fire.” Five year plans (or, worse, twelve year plans) never meet their goals.

3) Assume the low end of all economic forecasts.

From a financial perspective, the aughts will be long remembered for a time of easy money, asset inflation and irresponsibility on the part of almost everyone, from consumers to politicians.

Lucretia Hale, in her 1886 novel, The Peterkin Papers, has as her lead character, the “Lady from Philadelphia.” She was known for providing commonsensical solutions to what were simple, but to the Peterkin family seemingly impenetrable, enigmas. Should the lady from Philadelphia be presented the conundrum that is Greece, her solution would likely be, quit the Euro; reestablish the Drachma; deflate the currency; cut spending; set annual deficit targets. Of course that answer to Greece’s problem will worsen the situation in Germany and France. About €370 billion in sovereign and bank debt of Greece, Spain and Portugal sits in German and French banks. Nevertheless, default is going to happen. The only question is: what form will it take?

A unified Europe is a powerful ideal, a concept that emanated from centuries of internecine warfare, especially those of the century just passed. The elites of Europe felt that the prospect of a Euro to replace or complement the Dollar was a goal worth pursuing, if for no reason other than their antipathy to the United States. History suggests that to survive a unified currency must be preceded by a political superstructure – a stronger central government than now constitutes the European Union. As Mr. Stelzer writes, “The ‘European project’ won’t go quietly into the night. But it just might go noisily into the ashcan of history…”

Two years ago, Professor Martin Feldstein spoke at the American Economic Association meeting, which celebrated the 10th anniversary of the Euro. In that speech he alluded to the vast economic and financial differences between member states, suggesting the possibility of some sort of a future split. A comparison to America is not valid. Americans are more mobile than their European counterparts, and as wide as are the cultural differences between Texans and Californians, they are not as large as those between Greeks and Germans. It is hard to see a future in which the Euro, in its current form, survives. I hope this prognosis is wrong and that a way out is found, but I worry there is no easy exit.

Tuesday, May 10, 2011

It turns out that nobody wanted the crisis to go to waste. The recent credit collapse spooked us all. Responses varied. The Federal Reserve and Treasury are intent on ensuring that capital will be plentiful and virtually free. Congress has deemed that we all must be protected from ourselves, so that the Consumer Protection Act has become an integral part of the Dodd Frank Bill. Investors have become skittish, with “long term” having been shortened to a few days. Virtually every financial author has seen the crisis as an opportunity to create a best-seller. Legislators rack up poll points (and keeping their coffers filled) by condemning bankers, while asking them for money. Union leaders have chosen to ignore the message of low returns relative to expectations. Banks, who went to the wall in terms of solvency and who were saved by tax payers, continue to benefit after the crisis has passed in being able to borrow from the Fed at virtually no cost, while paying themselves handsomely and only grudgingly raising dividends. And the Press, unsurprisingly, is milking the crisis – not so much to inform, as to sell papers.

At least that was my reading of the piece by Mary Williams Walsh and Louise Story in yesterday’s New York Times, entitled “Seeking Business, States Loosen Insurance Rules.” The article begins with the fact that “states…are aggressively remaking themselves as destinations of choice for complex private insurance transactions once done almost exclusively offshore.” But this is a “dog bites man” story, and the tone is cautionary rather than hopeful. Four years ago, in the New York Times, Lynnley Browning wrote a similar story, “Vermont Becomes ‘Offshore’ Insurance Haven” (April 4, 2007.) According to the Vermont Captive website, the state is home to more than 900 captive insurance companies. Four years ago, according to Ms. Browning, there were 560 such companies in Vermont. These businesses contribute 2% to Vermont’s budget. They are important, but they are not new.

The article by Ms. Walsh and Ms. Story cited a few situations to support the notion that states (Vermont in particular) have loosened rules to attract business. They mentioned Aetna, which recently used a Vermont subsidiary to refinance a block of health insurance policies, reaping $150 million in savings. Three weeks after the deal closed, Aetna announced it was increasing its dividend 15 fold – from $0.04 annually to $0.60, implying a connection between the two events. What they did not point out was that Aetna had just earned $215.6 million for the quarter versus $165.9 million a year earlier and that they had $1.2 billion in cash on their balance sheet. Dividends are the surest way to return cash to investors.

“In 2008,” the two write, “MetLife used a subsidiary in Vermont to handle a crucial $3.5 billion letter of credit, with help from Deutsche Bank, because the subsidiary was not subject to the same collateral requirements as in New York.” The contract, as they point out, prevented the company from having to come to the government for assistance. Met Life agreed to pay Deutsche Bank $3.5 million for fifteen years – a total cost of $52.5 million, an expense described as “locking itself into high costs for years.” First of all, should we not be pleased that MetLife did not have to come to the taxpayers, as did so many financial institutions? And, second, $52.5 million represents 1.5% for the credit line, not out of line for a letter of credit, especially when the interest is paid over a number of years.

To the best of my knowledge none of the captive insurance subsidiaries based in Vermont required bailouts during the recent credit crisis. That does not mean investors should be complacent about potential problems. The insurance business, by definition, involves risk.

Captive insurance businesses are insurance companies established for the specific objective of financing risk emanating from their parent company. It is a form of self insurance. They tend to be formed during periods of rising rates – hard markets, to use the vernacular – as a means of reducing costs. Historically they were formed offshore in jurisdictions requiring lower capital and reserve requirements, places like Bermuda, the Cayman Islands, Guernsey and Luxembourg – places famous for deflecting sunlight. According to Ms. Browning, Vermont Governor Howard Dean in 2001 decided his state would “overtake Bermuda as the place with the most insurance captives.” While that has not yet been accomplished, Vermont, as of 2008, does now rank third, behind only Bermuda and the Cayman Islands. Today, the business employs 1400 people and has created a billion dollars in the state. And Vermont is certainly more open than these offshore domiciles.

Vermont’s success has not gone unnoticed, in this time of weak unemployment. Among the top twenty-five domiciles for captive insurance companies – again, as of 2008 – are six other states (Hawaii, South Carolina, Nevada, Arizona, Utah and New York.) and the District of Columbia. Last year, according to Ms. Walsh and Ms. Story, the number of similar businesses in Delaware doubled; Michigan is entering the business, exempting captives from taxes and charging only a fee. Even Connecticut, home to so many insurance companies, recently adopted a law permitting captives. Certainly reserve requirements will have to be monitored, because, as we all know, insurance is inherently risky. But why send the business offshore when they can be operated from home?

The credit crisis manifested many weaknesses of our financial structures. Those deficiencies have been largely addressed. On the other hand, in an increasingly globally competitive world, we must expect more creativity on the part of business to help grow the economy in non-traditional ways. Such growth will provide challenges for state and federal regulators, but to dampen inspired imagination serves no one well.

Monday, May 9, 2011

When Juliet asks the question of Romeo, she is not asking, where is he? That she knows. He is outside, below her balcony. She is asking, where does he stand in the feud between their families? Will he abandon the name Montague? To whom does he owe allegiance? The same question is being asked of Pakistan. Are they our ally in the war against Islamic terrorism? As the world’s largest Muslim country with nuclear weapons, can we afford not to keep them within our sphere of influence?

The question about Pakistan and our future relationship, in the short term, may hinge on determining who, if anyone, within the Pakistan government or their Inter-Services Intelligence (ISI), knew that Osama bin Laden was housed in a million dollar compound in Abbottabad, two miles from the Pakistan Military Academy, one of the country’s elite military schools. The answer seems obviously, yes, someone knew – even President Obama, on 60 Minutes yesterday, admitted as much.

Our long term relationship with Pakistan should supersede temporary setbacks. The President’s decision to keep the Pakistanis out of the loop was based on sound intelligence. Our future relations with Pakistan have been sublimated by the inane debate as to whether water boarding yielded some element of the intelligence that led to the discovery of bin Laden. Leon Panetta, CIA Chief, admitted it was a critical part of the mosaic. If one wants to understand torture, read Laura Hillenbrand’s Unbroken, which describes the Japanese treatment of prisoners of war during World War II; or, read what Islamic jihadists do to those they consider infidels – anyone who disagrees with them. What is important is that enough information was received so that the President was able to give a thumbs-up to the Navy SEAL mission that resulted in bin Laden’s death. The relationship has been given second seat to the endless and futile argument as to whether the photo of a shot bin Laden should be disseminated to disprove conspiracy theories. Does anyone really believe the bad guy is not dead? The Bush administration’s decision to release the photos of Saddam Hussein’s sons, Uday and Qusay, after they were killed in 2003 was based on the fact that they had terrorized the people of Iraq, so their people wanted confirmation they were actually dead. In this case, according to an IBD/TIPP poll, 89% of Americans believe bin Laden is dead.

The biggest reason not to show the photo of a shot bin Laden, in my opinion, is because it is in poor taste. Matthew Brady’s photos of dead union soldiers during the Civil War are evocative, as are those taken during World War II by Margaret Bourke-White. But there is no art in a digital photo of an aging, dead terrorist shot in the eye.

Pakistan is an ancient civilization embodied in a relatively young country. Artifacts found in the Indus Valley speak to a civilization that dates back 4000 years, yet the people only received their independence from the British Empire in 1947. With 170 million people, it is the world’s sixth most populous country and, behind Indonesia, the worlds second largest Muslim country. It is also one of the world’s poorest countries, with a median annual income of about $1000.00. Freedom has not come easily. Coup d’états; military rule; wars, both civil and external, and assassinations have marked their government during the past sixty-four years. Compounding the complexity, Pakistan has had nuclear weapons since 1972.

All countries manage foreign relations in their self-interest. The primary duty of the American President is to ensure the safety of its people at home and abroad. Foreign relations also serve to protect the trading interests of its people and businesses – keeping the seas free and open. We should do what we can to prevent conflict anywhere that affects our interests, especially when nuclear weapons are present, as they are in Pakistan.

While it is not our responsibility to impose our way of life on others, we cannot leave a vacuum if we cause political change, as we did in Afghanistan and Iraq and as we would like to see done in Libya. But we also cannot ignore the Arab Spring, which came as a surprise to many, and which has been a spontaneous eruption of the desire for freedom over autocracy. History shows that democracies rarely start wars, so it is in our interests to encourage advocates for democracy.

Pakistan has been a strategic ally against Islamic terrorism. The 1500 mile border with Afghanistan is often remote and mountainous and has served as a hiding place to Taliban and al Qaeda forces who would like to disrupt the fragile (but nuclear-empowered) government of Pakistan. Additionally, the disputed region of Kashmir has been a cause of tension between India, Pakistan and China – all nuclear powers. America and the world have an interest in a peaceful resolution. It is in our interest to prevent the government of Pakistan from falling into the hands of terrorists.

In reassessing our relationship with Pakistan, it should be remembered that Pakistani security forces have lost more than 3000, while killing or capturing over 400 al Qaeda members since 2001. Nevertheless, following the success of Navy SEAL team six, there is information the U.S. would like: Who within Pakistan has been aiding al Qaeda? Can bin Laden’s three wives, now in Pakistani custody, provide additional intelligence? And American authorities would like returned the tail section of the helicopter downed at the time of the mission.

In the final conclusion, it is in both countries interest to maintain civil relationships and I suspect they will. Pakistan is key to any withdrawal of American forces from Afghanistan. Being in possession of nuclear weapons, a stable Pakistani government is critical to the region. As Ahmed Rashid wrote in The New York Review of Books: “The ideology of global jihad that bin Laden espoused will not quietly disappear, for it has taken root in too many Muslim fringe groups.” Militarily and economically Pakistan depends on continued U.S. aid, and the U.S. is the country’s largest export market. The discovery that Osama bin Laden was within 40 miles of Islamabad was an embarrassment to Mr. Asif Ali Zardari’s government, and there are heads that should roll, but the relationship between our two countries should withstand this test. It is important that we do.

Thursday, May 5, 2011

In August 2007, the first indications of the oncoming credit crisis became apparent. In response to growing liquidity concerns, the Federal Reserve, on August 17th, cut the Discount Rate by 50 basis points – the first reduction of that magnitude in ten years. Despite rumblings in mortgage markets and already-falling home prices, the S&P 500 that August was 13% ahead of where it had been a year earlier. For two and a half months it continued to climb. However, during the following eighteen months, the markets provided a simile for prolonged, unending torture. Complacency, in markets as in war, can be your enemy.

Today, it is the blasé attitude of our government toward a continuing weakening dollar and the effect that weakness has on Treasuries and inflation that should concern us. In January 2002, the dollar stood at 120.14 (the Dollar Index.) The 1990s had been good for the dollar. It had risen 53% over the previous ten years. Yesterday it closed at 72.98, 39% below where it was nine years ago – and, worse, 13% lower than it was thirty years ago, according to David Wessel in today’s Wall Street Journal.

The dollar’s decline preceded the current administration by six years. Despite protestations to the contrary, the Bush administration pursued a weak dollar policy. During George Bush’s eight years in office, the inflationary consequences of too-low interest rates and too-aggressive spending caused the dollar to decline 22%. In January 2001, the Fed began a series of rate cuts. Over the next two and a half years, the Fed Funds rate was cut from 6.5% to 1.0% in June 2003. It remained at that level for a year, despite the fact that the mild recession of 2001 had ended in December of that year. Rates rose slowly for the next two years, but by the summer of 2007 Fed Funds remained 125 basis points below where they had been in 2000. The speculative boom in home prices has its roots in the Fed keeping rates too low for too long. During those same years, the surplus inherited by the Bush administration was turned into a deficit. The federal deficit during the Bush years, as a percent of GDP, rose from a negative 1.24% to a positive 3.19% in 2008 in 2008.

But a few bad decisions in the aughts should not legitimize continued weak dollar policies in the current administration. Like his predecessors, Treasury Secretary Tim Geithner has not walked his talk. He was recently quoted in Barron’s: “We will never embrace a strategy of trying to weaken our currency to gain economic advantage.” Nevertheless, under President Obama spending has increased so that the federal deficit is now close to 10% of GDP and Fed Funds have been kept close to zero. In the last two years the dollar has declined another 15%. Over the past few decades, our economy increasingly became dependent on a consumer who borrowed in order to maintain or improve his or her living style. That prodigal example was mirrored in a government with a belief in a never setting sun.

The official line from Washington is that a strong dollar is in America’s interests. I believe it is, and so do many others. But the administration does not, despite what they say. They crow about the rise in exports – up 21% in 2010, but they are only back to 2008 levels. The government continues to issue debt, with the Federal Reserve as the principal buyer, knowing that rates will eventually rise, as surely as the sun will set in the West, and that such increases will only pressure our deficits. It is an “eat, drink and be merry, for tomorrow we die” policy. Left to themselves, the administration would increase the debt ceiling with no restrictions on spending. So dollar debasement will persist, until a realistic road back is discovered.

The decision last week by the Treasury to exempt foreign exchange derivatives from the rigors of Dodd-Frank appear to be a preemptive move on the part of global corporations and banks to hedge (or speculate) on a further decline in the dollar. As Alan Rivoir of Brahman Securities recently wrote, regarding this decision, “whatever the explanation, there is more than the face value here. Something is certainly awry.” QE2 will be winding down next month, but a continued weak economy and a heavily indebted Treasury will persist in inflationary monetary tactics. Bill Gross of PIMCO wrote in his recent Investment Outlook”: “Investors in U.S. Treasuries are being shortchanged by 1-2% annually compared to historic norms.”

Inflation is not only punitive; it is insidious in the way it creeps up. In the forty-four years I have been in the securities business, the dollar has lost 85% of its value. In his April 8 issue of “Grant’s Interest Rate Observer”, Jim Grant contrasts official inflation releases to the far more realistic ones from Billion Prices Project, a daily real-time index compiled by two M.I.T. professors. The Billion Prices Project calculates inflation has compounded at 6.1% over the last six months versus estimates from the Bureau of Labor Statistics (BLS) of 2.8%. Anybody who buys gas or shops at a supermarket knows the official numbers are bogus. It has not always been this way. If one goes to the “Inflation Calculator”, it can be seen that the dollar doubled in value during the 19th Century. In contrast, it lost 95% of its value during the 20th Century.

As the nation faced an unprecedented credit crisis in 2007-2008, the Fed and Treasury acted swiftly and properly in liquefying the system and containing the damage. Over time, a strong currency reflects confidence; a falling currency denotes weakness. There are moments when a weak currency is beneficial, but it must be recognized as a tax on consumption, and it hurts the poor most of all.

Given the surge in asset prices such as commodities (at least until a couple of days ago) and in stocks, but not in wages or jobs, the question must be asked: Has a weak dollar policy overstayed its welcome?

Wednesday, May 4, 2011

The anti-Christie resides in Hartford. At least that is how Connecticut’s governor Dannel Malloy referred to himself after describing the New Jersey governor as “bombastic” in a New York Times interview in February, and after hearing Chris Christie’s response that he would be waiting at the border as taxpayers fled Connecticut.

Both governors, like those in several other states are facing large deficits. Cumulatively, state deficits in 2011 amounted to $191 billion, forty-five percent of which was the responsibility of ten states, all of whom have constitutionally mandated balanced budget provisions. What makes New Jersey and Connecticut so fascinating is that they have chosen two very different roads out of their respective labyrinths. New Jersey’s deficit, at 37.5%, is more dire than that of Connecticut, which is “only” 21.6%. However, there are only eight states whose deficit as a percent of their budget is greater than that of Connecticut, and the Nutmeg state carries the highest public debt on a per capita basis of any state.

The biggest difference between Mr. Christie and Mr. Malloy is that the latter has chosen to use tax increases to close roughly $1.5 billion, or roughly 45%, of the budget gap. Everybody, rich and poor, would be affected. For the wealthy, a luxury tax (ala Senator Mitchell’s infamous insertion into the 1990 federal budget of a similar tax, which failed to raise the expected revenues and devastated boat builders,) an increase in the top income tax rate to 6.7% and a hike in estate taxes. For the less fortunate, the new governor has proposed an increase in the sales tax to 6.25% from 6.0% and would broaden the number of products and services subject to such a tax. He would also raise taxes on gasoline and cigarettes.

In his February budget address to the Legislature, Mr. Malloy said that the sum of all the items in his budget could be summed up in one word: “jobs.” He is right, in that jobs are needed. He is wrong, if he expects that higher taxes will attract jobs, assuming he means private sector ones. He has to realize that there is competition for jobs and that the state must offer incentives – making the state “business friendly.” Instead, I fear, he will chase them away.

What Mr. Malloy, and others who occupy similar positions, will not admit is that it has been their spending programs and their lack of financial discipline that have brought us to this position. Over the past twenty years, according to Saturday’s Wall Street Journal, the population of Connecticut grew 9%, median income rose 54% and spending increased 146%. The problem is nowhere near as complex as the one that faced Sherlock Holmes in the “The Dog That Didn’t Bark.” We are in trouble because those with whom we entrusted the reins of government spent recklessly. As voters, ultimately we are responsible, but now the writing is on the wall in indelible, magic-marker lettering.

Behavioral economics play a role. When taxes increase, habits change. Like most politicians, Mr. Malloy fails to understand (or worse, maybe he does) that it is far easier for the wealthy to avoid taxes than the poor. It is they who can afford the high priced lawyers and accountants who can navigate between the Scylla of ever-moving tax rates and the Charybdis of ever-changing regulation.

The legendary hedge fund manager Michael Steinhardt was famous for clearing out his portfolio every year or so – selling all positions. Allegedly he did this because over the months there would be positions in the portfolio that, given what he now knew, should not be there. The selling was cathartic. It allowed him to start anew. His exceptional performance over more than three decades demonstrated the wisdom of his decision. Our governments (federal and state) should take similar action as regards the tax codes. In the past five years, the U.S. Federal Tax Code has grown from 16,845 pages to 71,684. What a difference it would be to start with a fresh slate – a one page tax form – that eliminated the myriad and mystifying tax deductions, credits and exemptions that proliferate throughout those pages! If we took such action, as time elapsed, we can be assured that new regulations, deductions, credits and exemptions would slip back in, perhaps to encourage (or discourage) human behavior. But, in the interim, the cleansing would provide renewed hope and confidence.

Thomas Jefferson once said: “Every generation needs a new revolution.” I would suggest that every generation needs a new tax code – one that starts with a blank slate.

The country and the states are facing massive debt problems and unsustainable deficits. A recovering economy may serve to mask the depths of those problems, but that relief (if in fact it occurs) would only be temporary. A Pew research piece out a couple of weeks ago suggested that the states’ shortfalls for retirement funds and retiree health plans were $1.26 trillion. According to Pew, if the actuaries who prepared the data had used a more realistic discount rate of 4.38%, the unfunded liability would have been $2.4 trillion.

There are those who argue that we should find a “middle way” through this dilemma, but it is always more important to find the right way. Divisive politics create tension; they are blamed for dividing the electorate along party lines; they create a fear concern that nothing will get done; but, again, doing the wrong thing is usually worse than doing nothing. This is no time to be centrist. The problems are too massive. The truth may not be politically palatable, but it must be faced. Many of those who measure and predict expected returns continue to live under the illusion that financial returns during the last thirty years are the norm. They are not. For the last thirty-one years, the S&P 500 (price only) has compounded at 8.5%, about 300 basis points above the very long term average . There is a debt and deficit problem. Unfortunately the solution will take radical measures, not typically found by those seeking consensus.